2 2: Economic Versus Accounting Measures of Cost and Profit

Indirect costs are expenses not directly linked to making products or delivering services. In the case of an automaker’s operations, indirect costs could include rent, insurance, supervisor salaries, and the electricity used to power the plant. Likewise, there are other business costs relevant to decision making that may not be considered as costs from the perspective of accounting standards. For example, the owner/operator of a proprietorship invests time and effort in operating a business.

When a company makes a normal profit, its costs are equal to its revenue, resulting in no economic profit. Competitive companies whose total expenses are covered by their total revenue end up earning zero economic profit. Accounting profit, rooted in conventional financial reporting, provides a clear snapshot based on explicit costs and revenues. However, economic profit introduces a richer dimension by considering implicit costs, notably the value of forgone opportunities. This distinction becomes pivotal in decision-making, influencing resource allocation and strategic planning. Economic cost, by contrast, provides a broader perspective by including both explicit costs and implicit costs.

A Broader Perspective

Their approach to costs reflects this forward-looking perspective, emphasizing decision-making relevance over historical accuracy. Every business owner must know the exact amount of money coming in and going out. Economic profit is more of a theoretical calculation based on alternative actions that could have been taken. Accounting profit, on the other hand, calculates what actually occurred and the measurable results for the period. If you stop producing cars, you don’t have to pay for extra raw materials and electricity. Opportunity cost emphasizes trade-offs, meaning that individuals and firms can allocate resources efficiently for high returns.

Role of Cost Accounting in Managerial Decisions

• On the other hand, you can use economic profit to determine investments and decide when to enter or exit a market.
• Another way to think of it is, accounting profit is the profit after subtracting explicit costs .
• If it declines one opportunity for another, the potential income from the declined opportunity is factored into economic profit but not accounting profit.
• There are a number of differences between explicit cost and implicit cost, which has been explained in the article presented below, have a look.
• Understanding the differences between accounting cost and economic cost is crucial for business leaders making strategic decisions.
• If the total spent on all these areas is $700,000, then that is the accounting cost.

This comprehensive view also explains why some apparently profitable businesses might close down. If a business shows positive accounting profit but negative economic profit, the owner would be better off pursuing alternative opportunities. Understanding this helps explain market dynamics and business behavior that might seem puzzling when viewed only through accounting measures. By calculating economic costs for each option, managers can identify which projects create the most value after considering all opportunity costs.

This principle dictates that only transactions quantifiable in currency are recorded. Factors like employee skill or customer service quality are not reflected unless directly measurable in money. There is the matter of the students’ time and energy, which is not reflected in the projection of the $27,200 profit based on last year’s operation. One way to measure that cost is based on how much they will forfeit by not using their time in the next best alternative, which in this case is the summer internship. We can consider this forfeited income as being equivalent to a charge against the operation of the ice cream business, a measurement commonly referred to as an opportunity cost.

Investment Decisions:

Similarly, noise pollution, water pollution etc. are examples of social costs. Private costs can be made equal to social costs by public regulation that requires the firm to install anti-pollution equipment. Companies periodically check if the standard costs differ from the actual costs. In the dynamic landscape of startup ventures, the evaluation of financial performance and strategic…

Accounting cost is relatively easy to measure, as it is based on actual expenses that are recorded in the company’s financial statements. It requires estimating the value of opportunity costs, which are not always easily quantifiable. This can make economic cost a more subjective measure than accounting cost. Economic profit is a form of profit that is derived from compare economic cost and accounting cost producing goods and services while factoring in the alternative uses of a company’s resources.

The opportunity cost principle 🔗

With this calculation, you may determine if an alternative business option could save your company money, and help you decide whether to pursue an alternative business venture. Economic costs include accounting costs, but they also include opportunity costs. Opportunity costs are the benefits you could have received if you had chosen one course of action, but that you didn’t because you went with another option. Imagine that you own a building and you use it as a warehouse for materials and finished products. The term “profit” may bring images of money to mind, but to economists, profit encompasses more than just cash.

Economists emphasize economic costs because they provide a more complete picture of resource utilization and efficiency. This approach helps answer fundamental economic questions about the best use of scarce resources. By including opportunity costs, economic analysis reveals the true trade-offs involved in any decision.

The comparison takes into account both the profits and costs a course of action would have avoided, as well as those of the actual course of action. Accounting cost is different from economic cost since opportunity cost is included. The actual expenses are nothing but the explicit costs which include wages and salaries, costs of raw materials, interest, rent etc. which are directly paid by the firm to the other parties. Economic cost provides a comprehensive understanding of what a decision truly entails, extending beyond mere monetary outlays.

The Importance of Economic Cost in Decision-Making

So social costs are higher than private costs when firms are able to escape some of the economic costs of production. For most companies, the ultimate goal is to maximize profits as much as possible. The costs incurred by a company weigh on its profit and ideally need to be minimized as much as possible. Costs that fluctuate with the volume of production are considered variable costs. That could include credit card transaction fees or shipping expenses for a retailer.

Unlike accounting and economic costs, sunk costs should not be considered when making financial decisions. In the realm of business and finance, the tension between accounting figures and economic reality is a subject of considerable debate. Accounting figures, often rooted in historical costs and standardized methodologies, provide a snapshot of a company’s financial health as per the accounting rules.

• By factoring in opportunity costs, businesses can optimize resource utilization and select paths that align with long-term goals and create value.
• Though an asset’s market value may change, its original cost remains the basis, with depreciation accounting for value reduction.
• A firm’s economic profit is less than its accounting profit because economic profit includes implicit and opportunity costs.
• Here, only variable costs are considered as production costs, while fixed costs are treated as period costs that must be covered by the overall contribution margin.
• Accounting profit is the profit after subtracting explicit costs (such as wages and rents).

For accountants who work in this area, software is increasingly important to determine the total economic costs of different options. Economic costs are critical to determining if there are lost opportunities for revenue that organizations miss by choosing one strategy over another. At its simplest level, it’s a way of determining how to use a company’s cash and resources to create the biggest profit.